The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, November 30, 2012

Office of Financial Research: looks for advice in all the wrong places

In his ProPublica article, Jesse Eisinger confirms your humble blogger's observation that the Office of Financial Research is a tool of the financial services industry to bury transparency.

Regular readers know that there are two pillars underlying the FDR Framework:

The philosophy of disclosure; and

The Principle of Caveat Emptor (buyer beware).

OFR was designed under the Dodd-Frank Act to bring as much opacity to the financial system as possible. Specifically, OFR can collect data, but it cannot share this data with market participants. It can only provide summary analyses.

As a result, the ability of the market to analyze the data collected by OFR is never brought to bear on the data.

As Mr. Eisinger observed,

But hardly anyone is paying much attention to the Office of Financial Research.

This entity was created by the Dodd-Frank Act to conduct independent research on the sweeping risks to the financial system. Ah, right, another group of Washington wonks who will issue reports carrying vague warnings of risks looming sometime in the uncertain future. Yawn. I hadn't paid much attention either.

But then I spoke to Ross Levine, an economist and specialist in regulation at Haas School of Business at the University of California, Berkeley, and I finally got it. The Office of Financial Research is a great idea.

Indeed it is as it is based on my call since the beginning of the financial crisis to create the "Mother of all financial databases".

And as I grasped it, I felt a minor sense of horror, as when you see a precious ring slip off a finger in slow motion and go down the drain while you are powerless to stop it.

This was exactly how I felt when I saw the supporters of the National Institute of Finance come bumbling into the space I had defined with the call for the "Mother of all financial databases".

The office is looking as if it will be a tool of the financial services industry, instead of a check on it.

Which is exactly what the National Institute of Finance and its supporters managed to achieve because they had not the slightest clue about what they were doing.

Its main role is to serve the Financial Stability Oversight Council, providing the systemic risk overseer with data and analysis of where the nukes are buried.

This is where they made there first mistake. OFR should never have been in the research business. It should solely have been in the business of overseeing a data warehouse run by a third party that collected, standardized and disseminate data to all market participants.

Everyone knows except the ego maniacs who were part of the National Institute of Finance that the market is better collectively at doing analysis than a handful of economists.

By insisting on doing analysis, the supporters of the National Institute of Finance opened the door for the Wall Street lobbyists to both neuter OFR and protect opacity in the financial system by burying transparency in the form of the "Mother of all financial databases".

But the Office of Financial Research was hobbled from the get-go by a poor design. It is housed in the Treasury Department, while ostensibly being independent of it. It has a small budget. And it has to report to the very regulators it is supposed to report on.

This month, it announced its advisory committee. Thirty big names charged with giving the fledgling operation direction and gravitas. But these same people have also compromised it.

A committee that by design substitutes for the market if OFR had been a tool to bring transparency to all the opaque corners of the financial system like I intended that it should be. Instead...

By my count, 19 of the 30 committee members work directly in financial services or for private sector entities that are dependent on the industry. There are academics, but many of them have lucrative ties to the financial services industry. I noted only one financial industry critic: Damon A. Silvers, the policy director for the A.F.L.-C.I.O....

The Treasury Department sees it differently.

"We were not looking for critics or proponents. That wasn't the goal," said Neal S. Wolin, the Treasury deputy secretary. "We were looking for people with a range of perspectives who understand keenly the systemic risks in the financial system."...

The world is teeming with expert critics of Big Banking; they just aren't heard from much in the halls of Washington.

The Federal Reserve Banks of Kansas City and Dallas have candidates. The economist Joseph Stiglitz would make a good choice. The Bank of England houses two prominent banking critics, Andy Haldane and Robert Jenkins. Outfits like Better Markets or Demos could nominate people who would give Jamie Dimon some indigestion.

Certainly, financiers are not a monolithic lot. Investors often have differing interests from those of banks, and investment banks from commercial banks, and the small from the large. Even in big institutions, there are secret sharers of anti-Wall Street sentiment. ...

Clearly, there is a place for finance professionals. But shouldn't the balance of the committee be tilted in the opposite direction and give greater voice to the critics and the banking skeptics? This is a panel that is supposed to identify giant risks in the system that bankers ignore in their pursuit of profit and bonuses and to spot flaws in regulations that could cost the public and economy trillions....

Imagine how all of these market participants could have been utilized to identify problems in the financial system if OFR were there to foster transparency rather than create opacity by monopolizing information.

So why does yet another Washington advisory panel of worthies matter? Mr. Levine has a subtle and fascinating answer. He starts by pointing to the mystery of the home-team advantage in sports, which has long puzzled researchers.

It turns out that umpires are biased toward the home team not out of conscious or recognizable bias. Rather, they subconsciously gravitate toward their immediate "community" — in this case, the home-field crowd, especially at crucial moments in a game. (Researchers will next study how this appears to have no effect whatsoever on the New York Jets.)

To minimize the bias, you can tell the umpires that they are being monitored. Introduce instant replay. With that, you have expanded the community that is watching the umpires to an audience far beyond the home crowd....

Which is exactly what happens when the data is made available to all market participants.

The Office of Financial Research is well on its way to barring the gate.

Before the crisis, the consensus was that the Office of Thrift Supervision was the regulator most in the pocket of Big Banking. For its efforts, it got shut down as part of the postcrisis regulatory overhaul.

"Now, the title of ‘Most Captured' is up for grabs," Mr. Johnson said. "And I think we have a contender."

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.